Ten Ways to Detect Chinese Stock Frauds

In the summer of 2011 Muddy Waters Research brought to light some suspect accounting practices from some U.S. listed Chinese companies, such as Puda Motor, Chinacast Education Corporation (PINK:CAST), Sino-Forest Corporation (TSE:TRE) (PINK:SNOFF) (FRA:SFJ) or China Electric Motor, Inc. (PINK:CELM). The general issues of accounting differences highlight China’s concerns to protect national and business secrecy (this appears to be the Chinese government’s main issue) and the U.S. government’s concerns regarding information disclosure and auditing capabilities. The issue is so thorny that many close observers think there’s a real

chance that the 200 or so Chinese companies with U.S. ADRs could possibly be delisted. Paul Gillis puts the chance of complete delisting at 20 percent. My guess is that there’s almost a 99 percent chance that the issue continues to get kicked down the road, at least through 2012.

Because the issues of reporting costs and disclosure are likely to be issues for a while, below are ways to investigate whether your investment in a Chinese company may turn out to be stock fraud, some of which are easier to accomplish than others.

1. Follow the short-seller sentiment: short-sellers tend to be sophisticated investors. If companies tend to dismiss or somehow disregard the arguments of short-sellers and instead the business continues on with things business as usual, that’s probably a good sign that the company is honest. On the other hand, if the company starts buying up shares, be wary.

2. Watch for too many mergers and acquisitions: it’s a red flag if the company appears to be coming up with the money for vertical mergers. Check out the competition.

3. Follow a companies’ cash balance sheet: when a business appears to be raising cash although they appear to already have more than enough cash on their balance sheet, it’s a red flag.

4. Figure out the board members’ connections: if the board member seems too close to Chinese government officials, it’s a red flag.

5. Check out the major investors: you’re on the same team if you end up investing, but before you invest, make sure you carefully investigate the ins-and-outs of how the major investors made their money and what their connections look like.

6. Lack of media exposure: Chinese companies will generally have English and Chinese websites. If there’s a difference in reporting quantity and quality between the local Chinese coverage and the English coverage, it’s a red flag. For instance, before the discoveries by Muddy Waters, Sino-Forest only had a few local China stories – somewhat odd for a company that, at the time, had a U.S. market cap of around $5 billion.

7. Look for related company transactions: if there are a lot of deals with one or two related companies, look into it.

8. Reverse mergers – don’t buy in, or at least do your homework: reverse mergers work like this. Suppose you are a private Chinese mining company wanting access to American capital markets, U.S. exposure, and the U.S. investor base. The simple way to become publicly traded in the U.S., generally OTC, is by merging with an already existent public company. The details vary, but the results can turn out bad. It’s a red flag for companies that can still do it.

9. Don’t buy it just because it has China in its name: Check out the SEC’s EDGAR database, such as the 8-K and 10-K filings. In these forms, you can find a lot of historical information about the nature of the business, its name changes, and so forth.

10. Check out board members’ families: if the extended family seems to be living beyond their means, check it out. An individual usually helps out those he cares about.